For those of us who invest in stock markets around the world, 2014 was a year of mixed returns. U.S. investors who invest in international stocks receive the returns in those markets in dollars, not yen or euros. In fact, even though some foreign stock markets had positive returns in their local currency in 2014, their returns were negative when converted back to dollars.
According to Bryan Harris of Dimensional Fund Advisors, the MSCI Europe (stock) Index returned 6.84% in euros but -6.18% in dollars in 2014. The difference was due to the decline in the value of the euro relative to the dollar in 2014. In other words, U.S. investors who invested in the European Stock Index had a negative return (in dollar terms) even though the European Stock Index had nearly a 7% return for the year. The return difference (in dollar terms) for U.S. investors is known as currency risk.
Should U.S. investors avoid currency risk altogether and just invest in the S&P 500? Only if they are willing to accept LOWER long-term expected returns. For the period from January 1, 1970 through December 31, 2013, the S&P 500 returned an annualized return of 10.4%. That's not bad until you compare that to a globally diversified portfolio that returned an annualized 12.8% over the same period—that is after deducting a 0.9% annual management fee from the return.
How can U.S. investors reduce currency risk? By hedging the value of the international currencies against the dollar. The tools to do this are beyond the scope of this discussion but does currency hedging pay off for investors? A recent paper by Vanguard explores this question.
The paper outlines (and analyzes) the key factors for those considering currency hedging.
The expected return on a hedged portfolio is lower than the expected return for the unhedged portfolio. Currency hedging is not free!
As the return volatility of the asset class increases (and exceeds currency volatility) the benefits of currency hedging decrease. For example, bond returns are typically much less volatile than stock returns. Currency hedging for international bond investors is more beneficial than for international stock investors.
Investors with a global stock portfolio allocated along the lines of the global stock markets hold about 50% of their stocks in the U.S. That leaves only half of their stock portfolio exposed to currency risk. Limiting bond holdings to high-quality U.S. bonds eliminates fixed income currency risk. So, an investor with a 25% U.S stock/25% international stock/50% U.S. bond portfolio, only exposes 25% of the total portfolio to currency risk.
A solid case can be made for using a currency hedge for an international bond portfolio. It is more difficult to make the case for adding the cost of currency hedging to an international stock portfolio.